When Patient Capital Grows Impatient

When Patient Capital Grows Impatient

Recaps” are Becoming more Popular as a Way to Satisfy the Diverging Needs and

Priorities of Shareholders
by François M. de Visscher

The Windham Co., a third-generation manufacturing company, had not surveyed its shareholders to evaluate their liquidity and capital needs in more than 20 years. The company had very effective shareholder information and communication programs. But when the 35 shareholders were interviewed in a recent survey, the leaders were surprised by the results. The composition of the shareholder base had changed. The estate and financial objectives of the shareholders had become quite diverse. The “patient capital” of this company had been well maintained through two generational transitions but was getting impatient.

The second generation, in their 70s and retired, was primarily looking for current income and wealth diversification while transferring the remainder of their shares to heirs. The third-generation members were in their mid-40s and raising families. Only one of them, the CEO, was active in management, and he was clearly looking for value growth. The rest wanted to supplement their incomes and plan for future expenditures such as college and possibly a second home. Some of the fourth-generation members were already in their early 20s and beneficiaries, through the family trust, of some company shares. Their priority was saving and wealth-building; their interest was in the long-term growth of the company. Many of the shareholders felt “trapped” in the same illiquid common stock, which paid only a modest annual dividend.

Windham (not its actual name) is not unique among later-generation enterprises in this respect. As the shareholder base grows, financial objectives inside the family become more divergent. Tension often starts to build, which may lead to the untimely sale of the company, or to some form of shareholder buyout.

In Windham’s case, a less drastic and more appropriate remedy was found: an ownership restructuring or recapitalization. Ownership restructurings and recapitalizations, so-called “recaps,” are becoming more popular among family companies. They involve reorganizing the ownership of the company to reflect the varying financial objectives of the multiple shareholders. Three of the most common forms are: the creation of multiple classes of stock; a stock restructuring with an optional redemption program; and an equity recapitalization.

Multiple classes of stock

Creating multiple classes of stock is one of the simplest strategies for dealing with the often clashing interests of active and passive shareholders. Typically, a company divides its stock into two new classes: one paying a higher dividend rate, the other carrying more votes.

Consider a fictional company, Donovan & Sons, owned by three brothers. The company starts with a single class of common stock with voting rights, divided equally among the three. Only two brothers are active in the business. Under the recapitalization, the company issues a new class of nonvoting Common Stock A, which annually pays double the dividend of the existing common stock. The new shares are distributed to all three shareholders as a dividend, in a ratio of one new share for every two old shares. Then the brother who is not active in the business gives up all his voting common shares to his two brothers in exchange for the new Class A Common Stock. The result is that the two active brothers end up with 100 percent of the voting stock, while the third brother owns 100 percent of the non-voting stock paying a higher dividend.

Redemption program

Since many of the 35 shareholders in Windham were not participants in the business and expected to have liquidity needs at different times, the ownership restructuring was coupled with an optional redemption program. The company issued a stock dividend to all shareholders of one share of a new $1,000 preferred stock for every share of common stock. The preferred stock is non-voting but pays a large fixed dividend of 10 percent a year. About 10,000 of these new preferred shares were issued, for a total book value of $10 million. At the same time, the company suspended any dividend on the common stock, which carries voting rights. Finally, it put $1 million into a redemption reserve for holders wishing to cash in shares of preferred stock-with the total amount the group as a whole can redeem in any one year limited to the $1 million.

The beauty of this type of recap is that shareholders can achieve liquidity through redemption of preferred stock without altering the control balance of the company. Every second-, third-, and fourth-generation shareholder would own shares of voting common stock as well as preferred shares. The second generation, more sensitive to current income and estate transfers, can keep their dividend-paying preferred stock, while gifting the common stock at a reduced value to heirs. Faced with large liquidity needs, the third generation, and even the fourth, can redeem preferred shares. Just as important, they retain an interest in the control structure through their common shares; they would thus have a keen interest in long-term value appreciation.

The equity recap

If the Windham shareholders had had more pressing liquidity needs, our firm could have recommended an “equity recapitalization.” The federal tax code allows a tax-free rollover of stock in an existing company in exchange for stock in a newly formed company having the same assets and characteristics as the old one. Recaps allow the family to cash in a majority of the value of their stock while still maintaining a substantial (25 percent to 50 percent) equity ownership.

Consider a company owned jointly by two brothers. With cash provided by banks and private equity investors, a new company purchases most of the brothers’ stock in the old company for cash. The remainder of their stock is contributed (exchanged) for a meaningful ownership percentage in the new company. Then the two companies are merged. Since this transaction is not considered a redemption, the cash received for the sale of stock is not taxed as ordinary income but, instead, receives favorable capital gains treatment.

The net result is that the two brothers achieve a large amount of liquidity and diversification, while maintaining a substantial equity ownership. They may even retain day-to-day operating control, if they so desire.

Needless to say, there are many variations on these types of recapitalization. Your legal and financial advisers can counsel you on the right alternative for your company. Just don’t wait 20 years to investigate the possibilities.

François M. de Visscher is founder and partner of de Visscher, Olson & Allen LLC, a financial consulting and investment banking firm in Greenwich, CT, for family and closely held companies.